Introduction

If you are an employee or a founder of a tech company, it’s imperative that you know about Employee Stock Ownership Plans (ESOPs).

While setting up an ESOP policy for OSlash, we realized one thing. Though the term is prevalent in the industry, both tech founders and employees actually understand very little about ESOPs. This can cause a lot of confusion and misunderstanding about their rights and obligations with respect to ESOPs.

To dispel the myths and bring transparency to how ESOPs work, we decided to pen this guide and share our learnings — sourced from founders of reputed tech companies such as Notion and Figma and also from our experience at OSlash.

1.1 What is covered in this guide?

Think of this guide as the ultimate playbook for understanding Employee Stock Ownership Plans (ESOPs) — for both employees as well as founders

This guide covers

1. An introduction to equity compensation in tech companies — its origin, how it is granted, and types of equity structures in companies
2. Why equity compensation is important for modern tech companies
3. What are ESOPs? - Basics
4. An understanding of ESOP valuation
5. Employee view of ESOPs — taxation, when to sell, and things to look for
6. Founder view of ESOPs — planning the ESOP pool, identifying the goals of equity compensation, and steps required to introduce an ESOP policy in the company
   

1.2 Who is this guide for?

• For employees whose compensation involves ESOPs
• For founders looking to set up an ESOP policy for their startup from scratch
• For founders looking for additional information to restructure their startup’s ESOP policy
• For anyone who wants to understand ESOPs but is confused by the jargon-heavy explanations on the internet

1.3 Why this guide?

• ESOPs have become an increasingly common form of compensation across tech companies, especially startups
• People are motivated to join startups that have attractive ESOP plans. But, there is a lack of simple, understandable information about how ESOPs work, with 57% of employees citing they would like more educational guides and FAQs on the topic
• There is absence of factually correct guidance for founders to set up their ESOP policy
• Founders struggle to correctly and satisfactorily explain ESOPs to employees

1.4 Disclaimer

• We are not lawyers. Please consult a lawyer before you adopt any of the recommendations we discuss in this document
• This guide is specific to the US employee stock option plans for modern early-stage tech companies. Most of the specifics might not translate to other jurisdictions

2. Understanding equity compensation

Because ESOPs form an important part of employee compensation at modern tech companies, let’s first understand how compensation is structured typically at an early-stage tech startup.

2.1 What are ESOPs?

ESOPs (Employee Stock Option Plans) are a form of equity compensation granted by companies to their employees and executives. With ESOPS, the company does not grant shares of stock directly, but gives the employee the option (or the right) to buy the company's stock at a specified price for a given period of time.

2.2 The structure of compensation in tech companies

Compensation in tech companies is typically a combination of the following components

• Salary: The monthly paycheck received by an employee
• Bonus: A time or performance-based incentive granted to employees once a year or on achieving a set performance benchmark
• Other benefits: These include perquisites (or perks) such as health insurance, expense reimbursements, retirement benefits, and other amenities such as certification courses, gadgets, gym memberships etc.
• Equity: Simply put, equity compensation is a stake in the ownership (and therefore the growth and profits) of the company. However, equity comes in various forms, and not all equity compensation grants employees the same rights and benefits in the company

2.3 What is equity?

As mentioned, equity refers to shares in a company’s ownership.

A company is a legal entity formed by a group of individuals to conduct a business. It has its own separate identity, distinct from the owners, such that the assets and liabilities of the company are not equal to the personal assets and liabilities of the owners.

Equity (and equity compensation) is affected by the ownership structure of a company.

There are two types of companies – private and public. Equity in a private company is restricted to its management, investors, founders, and employees. A public company, on the other hand, raises money by offering its shares to the general public via an IPO. Shares issued via an IPO are publicly traded in the stock markets and anyone can invest in them. By purchasing these shares, such shareholders get equity in the company.

2.4 How is equity different from equity compensation?

In both public and private companies, equity compensation simply means that employees are compensated by giving them a stake in the company. In other words, employees become shareholders in the company.

2.5 Equity compensation in tech companies — the history

The origin of equity compensation in tech companies (and the origin of Silicon Valley itself)  can be traced back to 1957 when theFairchild Semiconductor Corporation came into existence.

Founded by five scientists and three engineers, it was backed with a funding of $1.38 million by Sherman Fairchild, the largest shareholder in IBM. Each of the eight founders got to own 100 shares each, with another 300 shares reserved for managerial hires. The remaining 225 shares were taken by the two investment advisors who structured the deal.

The deal came with a condition: The investor, Fairchild, would have an option to buy shares from the founders and other shareholders at $3 million collectively if things went well. Things did go well and as a result, Fairchild could purchase all the shares from the founding team who became millionaires — receiving a quarter-million dollars each upon sale of their stakes.

2.6 Equity compensation in tech companies — the present

In his accredited 2017 book — America, Inc: The 400-Year History of American Capitalism — venture-backed entrepreneur, Bhu Srinivasan, notes about the Fairchild Corporation deal: “While the eight men made substantial windfalls, the investment structure lacked the unlimited upside element now intrinsic to the idea of the Silicon Valley start-up.”

To drive the point home, consider the compensation structure of Frank Slootman, the CEO of cloud computing giant, Snowflake Inc. Slootman led the company to what became the largest software IPO in history, raising $3.4 billion. Care to guess how much his ESOPs are worth?

Take a look:

His stock options: 13,921,409 shares with a strike price of $8.8, which equates to 5% of the company.

Snowflake’s share price (Mar 2022)= $200 (approx.) making the shares worth ~$3 bn, which is an upside of 2172%.

This, among other reasons, is why equity compensation is so attractive.

2.6.1 How is equity granted in tech companies today?

There are broadly two ways equity can be granted:

1. Stock options -  A stock option gives employees the right (but does not create an obligation) to purchase a fixed number of shares of the company’s stock at a discounted price at some time in the future. Hence, it’s called an option. It’s a contract that an employee signs with the company.
   

2. Stock grants - Stock grants are generally simpler to understand than stock options. Here, companies directly pay employees shares of stock as part of their compensation. It is not up to the employees to buy the shares. The shares are received simply as part of income on a periodic basis. They are more common among large, public companies.
   

Insider tip:
At OSlash, we prefer options over direct award of equity because we don't want our employees to pay taxes on the day of their receipt. If we provide them $10,000 worth of equity in a year, for example, tax authorities will count them as income and employees will be taxed in the current financial year. But if we give stock options (remember it's a contract), they don't have to pay taxes till it is actually exercised.

Both stock options and stock grants themselves come in many forms, giving birth to the different types of equity structures prevalent in companies today.

2.6.2 Types of equity structures

1. ISO - Incentive Stock Options

Incentive stock options (ISOs) allow employees to buy shares of the company stock at a discounted price and come with tax benefits. They are not taxed until the stock is sold. To earn a tax break, they need to be held for one year after exercising (buying the shares), and two years after they were granted. On sale, they are taxed at lower rates than the ordinary income tax rate.

ISOs are only valid for US citizens.

2. NSO - Non-Statutory Stock Options

As opposed to ISOs, non-statutory stock options (NSOs) are taxed at the ordinary income tax rate when exercised, irrespective of whether the shares are held or sold immediately after being bought.

While ISOs can only be granted to US employees, NSOs can be granted to foreign employees consultants, advisors, or business partners.

3. RSU - Restricted Stock Units

Restricted Stock Units (RSUs) are a form of stock grants. They represent the company’s promise to give you the shares or an equivalent value in cash after you spend a stipulated time in the organization.

While RSUs don't require employees to actually buy any shares, they are considered part of ordinary income and are taxed when they vest. This means employees at companies that haven’t gone public suffer a disadvantage — they may have to pay tax on shares that they cannot yet sell. Hence, RSUs are usually offered to senior executives in startups who can pay taxes on receiving the shares.

4. SAR - Stock Appreciation Rights

Stock appreciation rights (SARs) are a type of equity compensation different from both stock grants and stock options. They are linked to the company's stock price during a fixed period. So, employees make a profit when the stock price increases. Unlike ESOPs however, they do not have to buy any shares themselves. They are given the amount of price rise in stock or cash.

3. Why is equity compensation important for modern tech companies?

Equity is a powerful incentive for both employees and founders.

3.1 ESOP for employees

• The potential upside of being able to share in the profits of the company is high as equity can appreciate manifold as the company grows (while cash compensation might not). This offers employees a stake in the success of the company.
  

• The benefit comes from being able to purchase company shares at a nominal rate to sell them for a huge profit (best case scenario). There are several success stories where employees became millionaires together with founders of the companies.
  
  A very notable example is Google when it went public. Its founders Sergey Brin and Larry Page became the richest persons in the world, even the stock-holder employees earned millions.
  ‍
  In May 2018, over a hundred Flipkart employees turned dollar millionaires as the company was bought over by Walmart which purchased ESOPs worth $800 million.
  
  In September 2021, over 500 Freshworks employees in India — with 70 of them below the age of 30 — became millionaires when the company became the first Indian SaaS startup to list in the US. Today, 76% of employees own shares in Freshworks.
  
  “It gives me a great sense of fulfillment today. This IPO has given me an opportunity to fulfill my responsibility to all the employees of Freshworks till date who have believed in us over the last ten years and contributed to Freshworks,” - Girish Mathrubootham
  

• ESOPs come with tax benefits too, which we discuss later.

3.2 ESOP for founders

• The sense of ownership from ESOPs results in commitment and alignment with the overall company goals—if the company does well, the employees do well too. Hence, ESOPs can be used as a powerful motivator to boost productivity.
  

• ESOPs help attract talent. A senior executive from Google would not join an early stage tech company if they don’t have the significant upside of increasing the value of their ownership.

• ESOPs are a wonderful tool to help retain key talent.
  In 2016, Flipkart’s Chief People Officer, Nitin Seth shared with HT Mint: “It’s pretty fair to say that 35-40% of the organization is what we see as our critical talent to whom we’re offering stock of the company. The number has gone up significantly—in the past years, the number was 10-20%. This is the highest in the history of the organization in terms of the stock that we’ve offered.”
  

• They free up cash resources that would have otherwise been used for hiring talent. These can be invested in company growth instead.
  

• They also make compensation packages look more attractive especially if the company has a cash crunch
  

Now that we know how (and why) equity compensation works, let’s dive into everything founders and employees need to know about ESOPs.

4. Basics of ESOPs

Let’s assume you join a company which offers you ESOPs in addition to your salary and cash/non-cash benefits.

This is what it may look like:
‍You are offered 1000 shares of stock at $1 exercise price each with a 4-year vesting period and a 1-year cliff.

This means you have the option to buy 1000 units of stock in the company at $1 provided you meet a few predefined terms and conditions, as below.

4.1 What is the exercise price?

The exercise price (also called strike price) is the price at which you can buy the shares in the future irrespective of their actual (or market) price at that time. Your shares in the company may have a value of $10 each in 2030. Even then, you will only pay $1 to buy a share.

Do you see why ESOPs are so lucrative?

‍At OSlash, employees are offered a share at a strike price as low as $0.08 per share.

4.2 How to exercise your option?

Exercising the options means buying the shares guaranteed to you. Your options are essentially shares that you own in the form of a share certificate. You can exercise your options as you attain the legal rights to them — which happens periodically rather than in one go.

Insider tip:
You want to exercise the stock when you have the opportunity to sell it for a higher price than you are buying it.

Example:
In the above scenario, assume the stock price rises to $100. You still would be able to exercise your 1000 options by paying $1 per share i.e. $1000. This way you get to hold stock worth $100,000 at current value (a $99,000 profit).

You will be able to exercise the option within a predefined time period. This is the exercise period or the exercise window. After the exercise period, your options will expire.

The exercise window is usually:

• Seven to ten years as long as the person is working for the company
• Three to six months from leaving the company in case of termination of employment
  

At OSlash, employees can exercise the option up to eight years after leaving OSlash, provided they spend two years in the company.

4.3 What is meant by vesting, vesting period, and vesting schedule?

Vesting is the process of getting full legal rights to the shares. Rather than giving them all in one go when someone joins, companies treat ESOPs like compensation. They give it out in small chunks over time.  

Companies will usually not allow stock options or grants to vest to new hires immediately upon their joining. Instead, employees receive parts of their equity compensation over a set period of time known as a vesting schedule.

A four-year vesting schedule is a common practice across tech companies, including here at OSlash. We follow a four-year vesting schedule with a one-year cliff, followed by monthly vesting.

This means an employee at OSlash would receive their stock options as follows:

0% will vest in the first 12 months

25% will vest on completion of the twelfth month

The rest will vest every month

4.4 What is cliff in ESOP?

Cliff is the minimum period of time before you qualify to receive the first part of your options.

For the above example, the one-year cliff means that you need to be working with OSlash for at least one year before the first (one-fourth) chunk of your ESOPs vest. If you were to leave before the year, you would not receive any ESOPs.

Understandably, companies use ESOPs to increase employee retention rates and to motivate them to stay longer.

Insider tip:
Not all companies follow the same vesting schedule, however.
‍
Three notably famous cases in point? Lyft, Stripe, and Coinbase. All three giants have switched to a one-year vesting schedule. Their compensation packages have been changed so that employees’ entire stock awards vest in one year, instead of the traditional four years.

The reasons for accelerated vesting?

The market for high tech talent is intensely competitive. Companies are trying to make their compensation more lucrative. Moreover, faster vesting schedules often go hand-in-hand with smaller equity grants each year. They result in cost-savings for fast growing companies whose valuations are rapidly rising.

Coinbase justifies this decision as being more employee-centric. “We don’t want employees to feel locked in at Coinbase based on grants awarded 3 or 4 years prior. We want to earn our employees’ commitment every year and, likewise, expect them to earn their seat at Coinbase.

We are also eliminating the one-year cliff from our new hire grants. We expect new hires to add value on their first day, so it only makes sense for them to start vesting rewards for their contributions.”

5. Understanding ESOP valuation

The value of ESOPs depends mainly on

• The stage of the startup or company
• The valuation of the company, and
• The option pool

5.1. Stage and valuation of the company

Any venture-funded company like OSlash goes through different stages of fundraising, which impacts ownerships in the company.

OSlash is currently in the Seed stage. To understand how the company's valuation is determined, we need to understand the different types of shares in OSlash.

5.2 Different types of shares

There are two types of shares in OSlash — common shares and preferred shares.

1. Preferred shares are given to investors, advisors, and angels. Since they provide us with money and advice, they have some 'preference' before all of us
2. Common shares are the shares the management and employees of the company receive
   

Preferred shares are more expensive than common shares as they are entitled

• to receive dividends before common stock dividends can be issues
• to be paid from company assets before common stockholders in case of the company’s bankruptcy
  

The cost of preferred shares determines the valuation of the company.

Remember that when we talk about ESOPs, we are referring to common equity shares.

Because of the above differences, the strike price of ESOPs cannot be the same as the price of preferred stock.

Insider tip:
The option’s exercise price is usually at a 70 to 80% discount to the preferred share price established in the prior round of fundraising. As an example, if we sold preferred stock at $1, the exercise price for the common stock value at that time would be somewhere between 20 and 30 cents per share.

Moreover, the lower the strike price for common shares, the higher the number of shares that can be issued as ESOPs.

Getting to the exercise price is a challenging task. We need valuation consultants to come up with the right price. Companies like OSlash need to produce a valuation report called the 409a report.

We engaged a valuation consultant to come up with the report. The valuation is suitable for a whole year or until we raise more money.

According to the 409a report, the exercise price of OSlash common share is $0.08, whereas the price of a preferred share is $0.8. Preferred Shares are ten times more expensive than common shares.

As a result, OSlash employees get a discount of 90% as part of the ESOPs.

5.3 Option pool and dilution

The option pool (also called equity pool or ESOP pool) is a block of company shares that employers create, add to the existing number of shares, and set aside for future employees.

For example, if a company currently has 100,000 shares (100% of the company) and we create an option pool of 11,500 shares, there are now 1,11,500 shares of company stock on a fully diluted basis.

Note:
Fully diluted shares are the total number of common shares of a company that will be outstanding and available to trade on the open market after all possible sources of conversion, such as convertible bonds and employee stock options, are exercised.
(Source - Investopedia)

The ESOP pool is created by founders who dilute a certain percentage of their ownership to allocate to the pool (when the company is in its early-stage). If the ESOP pool is exhausted while there are still unmet hiring needs, further dilution may be done by founders (or even investors) to replenish the pool.

As a result, an ESOP pool affects existing ownerships in the company, impacts the share price, and thus the effective valuation of the company.

Example:
When OSlash raises money from investors, we create new shares to sell to those investors. Now, the existing shareholders (say management, employees, early-stage investors etc.) will own the same number of shares as before. But, there will be a greater number of total OSlash shares available so that they will now own a smaller percentage of the company. This is what dilution is.

From the above example, if owners held 10,000 out of 100,000 shares earlier i.e. 10% of the company, after creating the pool, they will hold 10,000/111,500 shares now or 8.97% of the company.

In an ideal scenario, as the company acquires new funding, grows, and scales, its valuation keeps increasing. As a result, the value of each share held by each employee/owner/investor also rises. This means that despite dilution, they end up getting more (and not less) in each successive round of valuation — a small share but one of a larger pie.

Insider tip:
A larger option pool is attractive for hiring new employees and investors. But as we have seen, the bigger the option pool gets, the more diluted the ownerships become. The key is to set the right balance, keeping your fundraising and hiring needs in mind.

6. Employees' guide to ESOPs

6.1 When to sell your shares

After the vesting period is over, the employee can usually exercise the ESOPs and sell the shares. Of course, it makes sense to sell the shares when the option is in the money i.e. the strike price (purchase price) is lower than the market price.

There are generally three occasions when an ESOP sale (also called Exit) is possible. You can sell your ESOPs

1. In a buyback during the next round of fundraising - It is a common practice for companies to buyback ESOPs from existing (and even former employees) during fresh rounds of fundraising. A new set of investors come in and take the ESOPs of employees and infuse capital in the company
2. When the company gets acquired (M&A) - The acquiring entity offers to buy existing ESOPs from the employees in order to complete the acquisition
3. When the company goes public (IPO) - Usually, shares of an unlisted company are illiquid as the above two instances are fairly uncommon. When a company offers ESOPs, the expectation is that the employees who show greater commitment and continue with the company would eventually reap the benefits, potentially upon a future IPO, when the shares can be sold to the general public
4. Secondary sales - This is more likely than an IPO in case of startup ESOPs. Employees can sell their shares after exercising their options to other shareholders such as existing (or new) investors
   

Private companies can also stipulate a lock-in period to make sure that employees do not sell the shares in the open market, as soon as they get them.

Since stock options have a shelf life (exercise window), if the company doesn’t go public, obtains the next round of funding, or gets acquired, within that time frame, your purchased options will expire.

6.2 Things to look out for

As you can tell by now, there are various clauses in an ESOP.

Before agreeing to receive ESOPs, understanding what you are signing up for is important.

1. The worth of your ESOPs - Don’t be blindsided by the higher number of shares on offer. It does not mean you get more equity. The worth of your shares depends on the percentage stake you own in the total number of shares of the company’s stock. To figure this out, ask your employer for the number of “fully diluted” shares, which includes stock that has not been issued yet, but could be issued in the future. You can then use the valuation of the company to get an idea of the worth of your equity compensation. (Refer the section on option pool for more clarity)
   ‍
   

2. Risk - ESOPs, especially at early stage companies, carry risk. More startups fail than succeed. So, it’s a gamble — in the worst case scenario, your ESOPs may be worth nothing. This is important especially where employers may offer you more ESOPs if you take a salary cut. In the best case, your company may be acquired or listed and you may reap huge benefits.
   
   Just like Sudharshan (Susa) Karthik, Ex-Senior Product Manager at Freshworks. “When Freshworks went public last year (2021), the upside on my ESOPs was something beyond my wildest dreams,” he says. “But it is important that young folks realize that ESOPs are not a get-rich-quick scheme by any measure. I see a lot of people joining startups hoping to cash in millions on their ESOPs, which is an extremely rare event. It’s far more rewarding to look at ESOPs as the best way to tie your inputs to outcomes in a company and as a career-building exercise.”
   ‍
   

3. Vesting schedule - As a rule of thumb, the shorter the vesting period, the more quickly you receive the options, and the more quickly you can exercise them. Prefer shorter vesting schedules and cliffs and be wary of vesting schedules that have disproportionately higher vesting in later years, as they can act like “golden handcuffs”, making leaving the company disadvantageous for you. Longer vesting schedules can also make you miss out on opportunities for exits.
   ‍
   

4. Liquidity and exit options - For listed companies, pricing is an issue, as their stock prices do not move in sync with performance. For unlisted companies, the problem is lack of liquidity and clarity on valuation. That is why companies must mention all exit options clearly at the time of grant. For instance, if the initial public offer is the only exit route, it must be stated clearly and the potential uncertainties related to listing brought to the employees attention.
   Source: Business Today
   ‍
   

5. Negotiation - Just like your cash salary, you should negotiate your ESOPs when you first sign a job offer. Think of ESOPs as any other investment opportunity. You want to maximize your gains while capping potential losses. When deciding how much stock to hold, assess your life-stage, finances, and risk appetite. Negotiate accordingly.
   
   “Like with other assets, diversification is also important for ESOPs. Don’t bank too much on ESOPs to make you extraordinary returns,” cautions Karthik.
   

Insider tip:
Don’t hesitate to ask questions from your employer about your ESOPs. Most employers will answer them happily.

6.3 Taxation

The tax treatment of ESOPs will depend upon the country of incorporation of the company as well as the nationality of the employees.

6.3.1 ESOPs given by foreign (say US) entities to Indian employees

The tax treatment for ESOPs given by foreign entities (such as a startup incorporated in the US) to Indian employees is as follows:

1. Upon exercise of ESOPs: The difference between the fair market value (FMV) of shares allotted and the discounted price (strike price) paid by an employee would be taxed as perquisite in the hands of the resident employee. The tax rate would be the ordinary income tax slab rate.
   

2. Upon sale of shares acquired: At the time of sale of shares, the profits will be taxed as capital gains. Short-term gains (where shares are held for less than 24 months) are taxed at income tax slab rates, while long-term gains are taxed at 20%  with indexation benefits
   

The company has to deduct TDS from the salary of the employees in the month in which allotment/transfer of shares is made.

Note:
In 2020, the Indian Government announced that payment of income tax on startup ESOPs can be deferred from the time of exercise of ESOPs. Now, the tax liability arises within 14 days from any of the following events, whichever is the earliest:

• after the expiry of 48 months from the end of the relevant assessment year; or
• from the date of the sale of ESOP shares; or
• from the date the employee ceases to be an employee of the startup that allotted the ESOPs
  

Liability for deducting tax at source (TDS) on the startup also stands deferred.

*These benefits are available only for eligible startups.

6.3.2 ESOPs given by US entities to US employees

The tax treatment here will depend on the type of ESOPs, namely ISOs or NSOs.

1. NSO
   ‍NSOs are taxed twice
   
   a. Upon exercise of the option: The spread between the fair market value (FMV) and the exercise price (also called strike price) is taxed at ordinary income tax rates. Employees are also charged employment taxes.
   
   b. Upon sale of shares acquired: To qualify for long-term capital gains treatment on the sale of stock purchased through an NSO, the shares must
   - have been held for at least one year after purchase
   - come from options granted at least two years prior to the sale
   

Stocks held less than one year after purchase or less than two years after grant date are subject to (higher) ordinary income tax treatment.
‍

2. ISO
   ‍One of the qualifications for avoiding taxation on exercise of an ISO is that it must be equal to the FMV at the date of the grant. Employees must pay AMT (Alternative Minimum Tax) on the amount the FMV exceeds the option price at the time of the grant.
   
   This is unlikely, but could occur in a scenario where they were granted at a certain price by the company and a new 409a valuation was completed between their grant/purchase and exercise.
   
   ISO stock is taxable at the long-term capital gains rate when the same conditions specified for NSO above are fulfilled. In the case that early exercise is allowed, ISOs are eligible for the 83 (b) election, which allows one to avoid their taxation as income and also starts the clock on their consideration as capital gains.
   
   You must file the 83 (b) election within 30 days! There are NO exceptions.
   

7. Founders' guide to ESOPs

7.1 How to plan for an ESOP pool in every stage of funding

As stated, to offer ESOPs, founders have to dilute a part of their own equity and create an ESOP pool. Employees are granted ESOPs from this pool. Further dilution may be necessary to replenish the pool in successive fundraising rounds.

Thus, the ESOP pool size is inversely proportional to the company’s growth stage – as the company scales, the size of the ESOP pool decreases.

7.1.1 Early Stage: ESOPs as compensation

Early-stage employees should get a higher reward (in terms of a higher share of ESOPs). They are taking higher risk by joining an unproven business venture and must be compensated adequately via ESOPs. Moreover, an early-stage company is quite illiquid. Attracting key executives in the absence of huge cash compensation is a problem that can be solved by giving more ESOPs as part of compensation.

7.1.2 Growth Stage: ESOPs as rewards

In the growth stage, the focus is on retention of key talent which drives growth. As the size of the ESOP pool reduces, it becomes prudent to reserve ESOPs for key personnel and award performance-based ESOPs. Moreover, as the company matures, and cash flows begin to improve, it is easier to award higher cash compensation to new employees who join than it is to dilute equity further.

Insider tip:
It is considered a best practice to award ESOPs to all employees in an early-stage startup, irrespective of their role and seniority. This kindles the ownership among all and gives impetus towards company’s growth.

7.2 Goals when structuring equity incentive schemes

The goal of the policy should first and foremost be to set your team up for success

7.2.1 Allow early team members to have an equity setup similar to founders

At OSlash, we have tried to ensure that we all get equitable treatment in the hiring process with respect to equity compensation.

Founders such as Girish Mathrubootham (Freshworks) instituted RSUs for every employee as they grew, a practice lauded by Karthik, who believes this is the best way to do right by the employees.

The very first employee at Flipkart, Ambur Iyyappa, also received shares in the company which fetched him millions upon sale.

7.2.2 Reduce the chance of team members owing equity-related taxes

It is advantageous to offer stock options over direct equity. For example, $10000 worth of direct equity will be counted as income and will be taxed in the current financial year at ordinary income tax rates. But, since an option is a contract to buy shares, employees don't have to pay taxes till they exercise it.

7.2.3 Reduce the chance of team members losing equity for some technicality

Good employers will always try to draft an ESOP policy that makes sure their employees come out winning. This can take many forms including front-loaded or accelerated vesting (where the majority of shares vest within a short period of joining), no cliff period, monthly vesting after cliff instead of quarterly vesting, longer exercise periods for employees leaving the organization, and lower strike prices so employees can comfortably shell out the money required to buy the shares etc.

7.3 Summary of steps required to introduce an ESOP policy at your company

1. Get the ESOP policy scheme draft prepared by your lawyer. You’ll have to figure out:
   

• How many ESOPs to award whom (illustration below)
• The strike price at which you will offer the options
• The vesting schedule and cliff (if any)
• The exercise period and conditions applicable on termination of employment/death/disability etc.
• Whether the ESOP will be administered directly by the company via its Board or with the help of an ESOP trust
• An exit price estimation
  

2. Communicate the policy to employees as clearly as possible and make the policy easily accessible to everyone.
   

Insider Tip:
Use OSlash to create a shortcut to your ESOP policy such that o/esop-policy can be accessed company-wide by everyone, every time.

3. You can conduct a company-wide session to explain how ESOPs work in detail and to answer any questions your employees may have
4. Register your ESOP policy and give grant letters to the employees

7.4 Actionable insights

Lastly, here are some actionable insights you may want to keep in mind before rolling out ESOPs at your startup:

1. The earlier you create your equity pool, the better it is. The best employers reserve 12-15% of ownership for the equity pool. Remember, it’s not just a best practice but also a humane practice to be generous when it comes to ESOPs
2. Your ESOP offering should change as the stage and valuation of your startup changes. Be flexible with ESOPs as your company grows and the balance between cash salaries and equity awards changes
3. Since the ultimate goal of ESOPs is to encourage employee ownership and alignment with the company, focus on creating value for your employees and provide them fair terms
   

To conclude, we’d encourage founders to look at ESOPs through the lens of an employee. Or as Sudharshan Karthik says, “Use ESOPs to make the pie larger for everyone rather than have them act as golden handcuffs.”